Nally, Inc., is considering a project that will result in initial aftertax cash

Question

Nally, Inc., is considering a project that will result in initial aftertax cash savings of $6.1 million at the end of the first year, and these savings will grow at a rate of 3 percent per year indefinitely. The firm has a target debt-equity ratio of .60, a cost of equity of 13 percent, and an aftertax cost of debt of 5.5 percent. The cost-saving proposal is somewhat riskier than the usual project the firm undertakes; management uses the subjective approach and applies an adjustment factor of +3 percent to the cost of capital for such risky projects.

Calculate the WACC. (Do not round intermediate calculations. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).)

What is the maximum cost Nally would be willing to pay for this project? (Do not round intermediate calculations. Round your answer to 2 decimal places (e.g., 32.16).)

Calculate the WACC. (Do not round intermediate calculations. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).)

Explanation / Answer

Requirement 1

WACC = Cost of Equity * Equity proportion in capital + Cost of debt * Debt proportion in capital

we know debt/equity = 0.6 which means ratio is 0.6:1 so Debt comprise of 0.6/1.6 of total capital and equity 1/1.6.

Therefore WACC = 13*1/1.6 + 5.5*0.6/1.6 = 10.1875 or 10.19 %

Requirement 2

Maximum cost that Nally would like to pay is the present value of all after tax cash inflows.

WACC = 10.1875% as calculated in requirement 1.

Since this is rikier project so adjusted WACC = 10.1875 +3% = 13.1875 %

Now present value of indefinite cash flows = Cash flow at end of year 1/ (WACC - Growth rate)

= 6.1/(13.1875-3)% = 59.8773 Million or $ 59.88 million

So Maximum cost that nally would like to pay for project is $59.88million.

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